Chief Investment Officer, Paul Harwood looks ahead into 2019.
Last year there was still momentum in the equity markets. The key risks were rising bond yields (resulting from economic growth and an end to quantitative easing) and specific company risk from underachievement of profit targets. Both factors played out during the year. As the year progressed, a different set of risks emerged:
- Trade tensions between the USA and China
- Slower growth in China and Europe
- Greater Brexit uncertainty
Entering 2019, economists seem to be emphasising the negative factors. In the US, an inverted yield curve (with higher yields for shorter duration) is said to be a predictor of recession. We think it is simply a reflection of much higher US bond yields attracting investment flows from international investors. This ‘imported liquidity’ may prove a support for the US housing and consumer markets.
Evidence from economic statistics is more sanguine. The latest US job creation figures were remarkably strong and growth is unlikely to have slowed materially from the annualised 3rdquarter rate of 3.4%, despite weaker manufacturing and export trends.
Subsequent to the Federal Reserve Bank’s December 2018 rate increase of ¼%, it has now acknowledged that it must be more sensitive to international influences. This suggests that with little threat to its inflation targets (given US Dollar strength and lower oil prices) it may ease back on its central forecast of two further ¼% rate increases in 2019. This will be at some cost to the US trade balance as the primary growth driver remains consumer spending.
Much is said about slowing growth in China and this caution is exacerbated by a lack of trust in the figures themselves. On the latest official quarterly numbers, annual growth has slipped from 6.5% to 6.3% but most believe the fall is greater. In response the Chinese government has relaxed its capital requirements for the banking system in an effort to reinvigorate lending and growth. We take the view that China can manage what may well be substantial bad debts from a heavily indebted corporate sector and from Government itself. This will be achieved through massive debt write-offs. On this view and with the opportunity to increase private consumption from under 40% of GDP to nearer western levels, China can still move forward.
Central to the growth outcome for the US and China will be the degree of success from ongoing trade discussions. The Chinese are reported to be confident. Trump’s negotiating tactics seem to involve much bluster followed by reflection and eventual acknowledgement of the practicalities e.g. North Korea, Syria and the Mexican “Wall”. On this interpretation, reason should prevail. Perhaps a stimulus to Chinese private consumption would assist here through the generation of increased import demand from western economies.
European growth looks to have slowed to a little under 2% in 2018. In 2019 quantitative easing will end but there is partially offsetting fiscal policy in France and Italy which could be followed elsewhere if growth slows further. The European Central bank appears to be acting less aggressively on its budget deficit target as both France and Italy will probably breach their 2% of GDP targets this year. We think growth will indeed slow in 2019 as the German economy sees weakness in its important manufacturing and industrial sectors. This is unlikely to be compensated for by the limited fiscal easing despite steady consumer demand.
The UK economy will have grown by around 1.5% in 2018, with consumer spending supported by high employment levels and marginally higher real wages. Exports have been resilient, aided by lower Sterling. Construction (other than housebuilding) and capital investment have declined, partly due to Brexit uncertainty.
Brexit negotiations have been poorly conducted and only now, when EU negotiators can see the risk of failure, is some respect being shown for the UK. This could enable a withdrawal deal to be approved by Parliament if there is a substantially improved “backstop” provision. Most Members of Parliament would prefer a second referendum but this would introduce new complications and perhaps 12 month time delay. An outside possibility is that Corbyn would welcome a “no deal” Brexit (despite protestations to the contrary) as the resultant difficulties would be blamed on the Conservative Party and could lead to an early General Election!
Slowing global growth, US/ China trade tensions and Brexit all point to continuing investor caution. The absence of quantitative easing in the US and Europe will also curtail enthusiasm for investment markets.
In the US, earnings growth is forecast to be just under 10% for 2019 resulting in a prospective P/E Ratio of 15x; close to the long term average for the S&P 500 Index. This seems appropriate given the late stage of this economic cycle and already elevated profit margins.
European equities look better value on most measures including a prospective P/E Ratio of 12x on the STOXX Europe 600 Index. Profit expectations here may be set too high and there is a risk of Euro weakness if any of the inherent problems within the EU political and economic system are exposed.
In the UK, at the start of 2018 we considered the 3.5% yield basis good value, despite our acknowledgement of risks which were becoming apparent then. 12 months later the FTSE All Share Index yield is close to 4.5% despite bond yields being little changed. Stock market weakness and higher earnings have dropped the average P/E Ratio materially and on current forecasts the FTSE ASI P/E Ratio is under 12x for 2019. At this rather depressed level there is scope for positive surprises on profits/earnings and also on the valuation basis for those earnings.
Cyclical and many growth sectors saw the greatest share price declines in 2018. Part of this should reverse in 2019 if our analysis of the economic outlook is correct. Pessimism over consumer spending has also been overstated, perhaps because commentators have failed to distinguish sufficiently between sales revenues and profitability. We acknowledge the competitive threat in many consumer retailing and leisure industries but we have been able to invest in areas less vulnerable to the internet threat and general overcapacity.
Against this volatile and uncertain backdrop we continue to identify and back a number of high quality, well capitalised companies across a variety of sectors which adhere to our strict investment criteria. Recent weakness in equity markets has presented opportunities in a number of companies which enjoy robust secular growth opportunities and remain less dependent on overall changing economic growth patterns.